Reassessing the Effects of Bilateral Tax Treaties on US FDI Activity

The impact of bilateral tax treaties on foreign direct investment (FDI) is surprisingly unclear. This ambiguity exists amid fairly pervasive empirical evidence that cross country variation in taxation does influence the distribution of FDI activity (e.g., Gresik 2001; Gordon and Hines 2002; De Mooij and Ederveen 2003; Blonigen 2005: Davies et al. 2009: Blonigen et al. 2014), as well as the fact that tax treaties are costly to negotiate and implement, yet nonetheless cover much of today's bilateral FDI activity. Specifically, the number of tax treaties in force has increased from 100 in the 1960s to over 2500 more recently (Egger et al. 2006). The US presently belongs to roughly 60 such treaties, covering approximately 78% of total US outbound FDI and 96% of total US inbound FDI, with over one-third being implemented since 1990 (Blonigen and Davies 2004). Furthermore, more than 40% of all US imports in 2009 were between related entities (The US Census Bureau). In light of these statistics, and the well known facts regarding the growing importance of FDI, understanding the effects, if any, of bilateral tax treaties on FDI activity is paramount.1

While the theoretical literature on bilateral tax treaties is more developed, empirical studies are relatively sparse. Blonigen and Davies (2004, 2005) find strong positive effects of 'old' tax treaties on FDI, but negative effects of 'new' tax treaties, using 1980-1999 US and 1983-1992 OECD data, respectively, particularly when modeling FDI in levels (as opposed to logs).2 Egger et al. (2006) also obtain a significant negative effect of 'new' tax treaties on OECD outbound FDI from 1985 to 2000 using a difference-in-difference propensity score matching estimator. On the other hand, di Giovanni (2005) analyzes cross-border capital flows for mergers and acquisitions from 1990 to 1999 and finds positive effects of tax treaties. Similarly, Stein and Daude (2007) obtain a positive and statistically significant effect using data on OECD outbound FDI stocks from 1997 to 1999. Millimet and Kumas (2009) obtain some positive effects when allowing for both anticipatory and lagged effects of treaties, but primarily for US inbound FDI only. Finally, Davies (2003a) finds no effect of revisions of existing bilateral tax treaties on FDI, and Hartman (1985) and Sinn (1993) find that the expansion of activities of multinational enterprises (MNEs) is essentially independent of withholding taxes. Davies (2004) provides an excellent review.3

The mixed, and perhaps counter-intuitive, empirical results - as well as the salient role played by the decision to model FDI in levels or logs - could be an artifact of the empirical approach that overshadows nearly all of these previous studies: the focus on the mean impact of bilateral tax treaties. As is clear from the literature, there are three likely effects of tax treaties. First, tax treaties may remove barriers to FDI through reductions in withholding taxes and double taxation, as well as by clarifying tax definitions and providing methods for dispute resolution. For example, the introduction to the OECD's model tax treaty states that primary goal of such treaties is "removing the obstacles that double taxation presents" to decrease its "harmful effects on the exchange of goods and services and movement of capital, technology, and persons" (OECD 1997, p. I-1). Similarly, the United Nation's draft manual for negotiating bilateral tax treaties states that the aim of such treaties is to "encourage economic growth by mitigating international double taxation and other barriers to cross-border trade and investment" (p. 2).4 Moreover, existing tax treaties always reduce withholding tax rates (Blonigen and Davies 2004). However, the second likely effect of tax treaties is the reduction of transfer pricing and other means of tax avoidance. In fact, the UN's draft manual continues by stating that a second objective is "to improve tax administration in the two Contracting States by reducing opportunities for international tax evasion" (p. …

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